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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
From Which Consumption-Based Asset Pricing Models Can Investors Profit? Evidence from Model-Based Priors
Mathias S. Kruttli
Abstract

This paper compares consumption-based asset pricing models based on the forecasting performance of investors who use economic constraints derived from the models to predict the equity premium. Three prominent asset pricing models are considered: Habit Formation, Long Run Risk, and Prospect Theory. I propose a simple Bayesian framework through which the investors impose the economic constraints as model-based priors on the parameters of their predictive regressions. An investor whose prior beliefs are rooted in the Long Run Risk model achieves more accurate forecasts overall. The greatest difference in performance occurs during the bull market of the late 1990s. During this period, the weak predictability of the equity premium implied by the Long Run Risk model helps the investor to not prematurely anticipate falling stock prices.


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Mathias S. Kruttli, From Which Consumption-Based Asset Pricing Models Can Investors Profit? Evidence from Model-Based Priors, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2016-027, 29 Mar 2016, revised 26 Sep 2016.
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Keywords: Bayesian econometrics; Consumption-based asset pricing; Return predictability
DOI: 10.17016/FEDS.2016.027r1
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